Investors Cooling on 'REO-to-Rent'

For the past three years they have been swarming over the hardest hit housing markets, buying distressed properties in bulk and pushing prices higher by double digits. The idea for these investors was not to buy and flip, but to hold and rent. Now some investors say they have priced themselves out of the market.

"Higher prices are reducing returns on investment, and investors are responding by cutting back on their purchasing plans until conditions sort out," said Chris Clothier, a partner in MemphisInvest.com and Premier Property Management Group, which commissioned a national survey of investors conducted by ORC International. "Fewer foreclosures, rising property values and competition from hedge funds are making it tough to find good deals on distress sales."

Nearly half the investors surveyed said they planned to cut back on purchases of homes in the coming year; in a survey last August, just 30 percent said they planned to cut back. Only 20 percent of investors said they plan to increase purchases, compared with 39 percent who said they would last August.

"We think the market is a little bit too frothy," said Carrington's Rick Sharga in an interview last month. Home prices are now up 12 percent from a year ago nationally, according to CoreLogic, but have risen far more greatly in formerly distressed markets where investors originally focused their purchases.

"The general consensus right now is that the bargains are drying up when it comes to buying foreclosed properties," adds Sharga.

That is largely due to a lack of distressed homes for sale. The number of foreclosure sales in the first quarter of this year fell 22 percent from a year ago, according to RealtyTrac, a real estate website. The number of short sales, when the home is sold for less than the value of the mortgage, also fell, as rising prices provided less incentive for banks to agree to such deals. Some claim banks are actually holding onto repossessed homes, waiting for prices to rise higher.

Investors accounted for 19 percent of home sales in April, according to the National Association of Realtors, down from 24 percent in all of 2012. Investors include individual buyers as well as large hedge funds, but the hedge funds have been getting much of the attention, credited with juicing prices in the hardest hit housing markets like Phoenix and Las Vegas. Their so-called REO-to-Rent strategy (Real Estate Owned-to-Rent) has evolved into a new asset class, with two of the companies that engage in the practice going public this year as real estate investment trusts (REITs).

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Still, the institutional investors are far from dominant players.

"Institutional investors play an extraordinarily small part," says Laurie Hawkes, president and COO of Phoenix-based American Residential Properties, which went public in May. "If you look at the number of dollars that are absolutely invested at this point, it's probably between 12 and 15 billion. On a house basis, that's about 120 thousand houses. If you think about the houses that have moved into the rental market due to subprime, it's about 5-6 million households, so if you do that math, it is a very small percentage."

Hawkes says she sees no shortage of opportunity in the space, since the rental market has grown so large and the costs for investors are still lower than replacement costs. Rents are still rising along with home prices nationally, but they are falling in the markets where investors initially set their sights.

"Single-family rents in the cities surrounding Phoenix proper— where all the 'investors' bought all the foreclosures—have plunged 25 percent in the past 5 months," says Hanson, who recently visited the market, meeting with rental agents and investors.

Hanson also points to a high vacancy rate among investor rentals. Still, over half the investors surveyed by ORC International said they plan to hold them for at least five years. One third said they would hold for 10 years or more.

"Investors aren't going to dump a lot of properties into a market and run the risk of losing money or devaluating the rest of their portfolios," he says.